Tuesday 16 November 2021
And so, it came to pass. After an extended period (seven years and counting) of thinking, deliberating, drafting, re-wording, re-phrasing, the IASB’s wordsmiths put down their pens. IAS 1, as amended = job done. Current v Non-Current, redefined and clarified = sorted.
Or so it seemed.
You can perhaps imagine the scene, the technical team in good spirits, about to say their goodbyes, ready to move onto the next project in the adjoining room (“Booked for the ISSB – Not to be Opened Before November 3rd, 2021”). And then the phone rings; “Hey everyone, great job, we’re really liking the look of these new paragraphs you’ve put down. You’ve delivered good. Just one thing. Before you go, can you just have one more look at 69(d), and 72(a). Yeah, I know that’s like, most of what you’ve been working on, but just a quick glance, a little check, something’s come up”.
Now, for a little recap: the purpose of the Board’s amendments to IAS 1, as we discussed in the first part of this article, is to provide greater clarity as to what constitutes a non-current liability, knowing that if it’s not non-current, then it must be current. The correct classification rests upon whether, or not, a right exists to defer settlement of the liability for at least twelve months after the reporting date. Or, to put it in the exact words of paragraph 69 (d); an entity classifies a liability as current when ‘it does not have the right at the end of the reporting period to defer settlement of the liability for at least twelve months after the reporting period’.
The aim is to avoid room for judgement making, for example where deferral might be based on management expectations. It seems clear cut. No room for doubt. If the right to defer exists, then it’s non-current. If the right does not exist, current – fact.
So, if we revisit the illustration from Part I of this article – reproduced below, with the classification (per the guidance of the amended IAS 1) now added - we should be in agreement with the presentation so determined.
For each of the following scenarios determine whether the loan commitment of Abacus should be presented as a current or a non-current liability. Determine the classification based upon the recent amendments to IAS 1 (as discussed above):
- Abacus has a loan commitment due for repayment on 30 September 2022. The reporting date is 31st August 2021. Suitable authorisation for publication occurs on 14 October 2021. How would the loan be presented (according to the amendments to IAS 1) if the following occurred?
- At the reporting date the lending conditions are being met. (Non-Current)
- At the reporting date the lending conditions are not being met, but in any event the lender does not test the conditions until a later date. (Current)
- At the reporting date the lending conditions are not being met. On 10th September 2021 the lender grants a twelve-month grace period for settlement. (Current)
- At the reporting date the lending conditions are not being met and settlement occurs on 10th September 2021. (Current)
- At the reporting date the lending conditions are not being met but are rectified on 10th September 2021. (Current)
- At the reporting date the lending conditions are being met, yet management intends to make settlement on 1st August 2022. (Non-Current)
- At the reporting date the lending conditions are being met and settlement occurs on 10th September 2021. (Non-Current)
Now, to the problem. Let’s focus on example two above, and specifically the issue of the entity having to comply with lending conditions to have the right to defer settlement, but these conditions are tested at a date later than the reporting date. You can maybe see where this is headed? According to the strict wording of the revised standard, if deferral rests upon the meeting of conditions at the reporting date, and those conditions are not tested until after the reporting date, then how can it be determined whether the conditions are being met at the reporting date?
This apparent impossibility of compliance is the reason for that hypothetical ‘final call’ to our hypothetical technical team above and is the subject of new deliberations on IAS 1, which, in all probability, will lead to the board issuing an amendment to its amendment.
Here’s the paragraph that’s really under the spotlight.
Paragraph 72 (a); ‘If the right to defer settlement is subject to the entity complying with specified conditions the right exists at the end of the reporting period only if the entity complies with those conditions at the end of the reporting period. The entity must comply with the conditions at the end of the reporting period even if the lender does not test compliance until a later date’.
With 69 (d) and, especially, 72 (a) in mind, let’s consider these three cases below, as reproduced from the IFRS Tentative Agenda Decision and Comment Letters: Classification of Debt with Covenants as Current or Non-current (IAS 1). These were used to test the application of the two paragraphs, upon which comment from stakeholders was sought.
An entity has a loan with the following contractual terms:
- the loan is repayable in five years (i.e., at 31 December 20X6).
- the loan includes a covenant that requires a working capital ratio above 1.0 at each 31 December, 31 March, 30 June and 30 September. The loan becomes repayable on demand if this ratio is not met at any of these testing dates.
- the entity's working capital ratio at 31 December 20X1 is 0.9 but the entity obtains a waiver before the reporting date with respect to the breach at that date. The waiver is for three months. Compliance with the covenant on the other testing dates continues to be required.
- the entity expects the working capital ratio to be above 1.0 at 31 March 20X2 (and the other testing dates in 20X2).
In this example the board’s conclusion is for the loan to be ‘current’ and, perhaps, appears reasonable based on the wording of the amendment. Afterall, the lending conditions are not being met at the reporting date and even though a waiver has been granted by that date it does not provide deferral for at least twelve months. The expectation of future compliance would always be irrelevant, surely. Expectation is just that - expectation. (By the way, I will not be with you next week as I expect to win the lottery this very evening).
The fact pattern is the same as Case 1 except:
- instead of the condition described in Case 1, the covenant requires a working capital ratio above 1.0 at each 31 March (i.e., the ratio is tested only once a year at 31 March). The loan becomes repayable on demand if the ratio is not met at any testing date.
- the entity’s working capital ratio at 31 December 20X1 is 0.9. The entity expects the working capital ratio to be above 1.0 at 31 March 20X2.
In this example the board’s conclusion is for the loan to be ‘current’ and, perhaps, appears reasonable, based on the wording of the amendment. Afterall, the reporting date is 31 December, and the testing date is the following March, so purely as a matter of fact, at the reporting date it cannot be proven whether the conditions are, or will be, met.
The fact pattern is the same as Case 1 except:
- instead of the condition described in Case 1, the covenant requires a working capital ratio above 1.0 at 31 December 20X1 and above 1.1 at 30 June 20X2 (and at each 30 June thereafter). The loan becomes repayable on demand if the ratio is not met at any of these testing dates.
- the entity’s working capital ratio at 31 December 20X1 is 1.05. The entity expects the working capital ratio to be above 1.1 at 30 June 20X2.
In this example the board’s conclusion is for the loan to be current and, perhaps, appears reasonable, based on the wording of the amendment. Afterall, the reporting date is 31 December, and whilst one part of the conditions is being met at that time, it’s impossible to tell whether all the conditions are, or will be, met. We’re not yet at the following 30th June and expectation is just that, expectation. It’s a lottery.
So, there we have it. It’s what might be described as an unintended consequence – the board seeking to provide clarity but opening the door for more potential uncertainty elsewhere. A lack of appreciation of the commercial realities of lending and debt covenants appears to be the issue here, certainly for those who commented.
Consider this extract from the letter (there are 38 of them) of one such stakeholder – Deloittes.
“We strongly believe that the Board should reconsider the conclusion reached in the recent amendment to IAS 1 to ensure that it provides a principle that results in relevant classification of debt with covenants as current or non-current.
We are concerned that it will be challenging for users to understand whether a reclassification of a debt as current is due to a theoretical breach of a future covenant or an actual breach at the reporting date. The implications of these two situations may be significantly different and the current Standard fails to differentiate between them.
Additionally, classification as current in the circumstances described in cases 2 and 3 may not provide relevant information about liabilities due to be repaid within 12 months from the reporting date and may be inconsistent with other disclosures, such as going concern. This could cause significant confusion amongst users.
For these reasons, therefore, we do not consider that it would be appropriate to finalise the agenda decision and we strongly suggest that further standard setting activity by the Board is required.”
In response the Board plans to publish an exposure draft which would;
- modify the requirements introduced by Classification of Liabilities as Current or Non-current (2020 amendments) on how an entity classifies debt and other financial liabilities as current or non-current in particular circumstances; and
- defer the effective date of the 2020 amendments to no earlier than 1 January 2024.
The emphasis here is mine – those circumstances being the testing requirements / testing date ‘issue’ of 72 (a). The effective date is now pushed back from 2023.
The ED is due for publication before the end of the year. No doubt this will be a discussion point on our upcoming IFRS Update and Application Briefing - our first course back in-person, face-to-face. A chance for us to pick up, once more, our (IASeminars) pens.
We hope to see you there.
Click here to read Part 1 of this article
Click here to read Part 3 of this article
Click here to read Part 4 of this article